Chapter 9

Chapter 9

Project Analysis

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Topics Covered

?How Firms Organize the Investment Process ?Some "what if" Questions

?Sensitivity Analysis ?Scenario Analysis

?Break Even Analysis ?Real Options and the Value of Flexibility

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Capital Budgeting Process

Capital Budget - The list of planned investment projects.

The Decision Process

1. Develop and rank all investment projects

? Capital Budget (bottom-up) and Strategic Planning (top-down)

2. Authorize projects based on different categories of projects

? Government regulation (e.g. pollution control project) ? Maintenance or cost reduction (e.g. machine replacement) ? Capacity expansion ? Investment for new products (depending on strategic decisions)

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Capital Budgeting Process

?Capital Budgeting Problems

?Consistent forecasts

? Different divisions may have different prospect ? Establishing forecast of economic indicators centrally

?Conflict of interest

? Agency problem (managers vs. stockholders)

?Forecast bias

? Over-optimism is a common feature in financial forecasts, for instance, large public expenditure proposals

? Politics inside the firm

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Capital Budgeting Process

?Selection criteria (NPV and others)

? Impose capital rationing to force the subunits to choose good projects

? Positive NPVs are plausible only if your compnay has some competitive advantage (e.g., first-entrant advantage, proprietary technology, lower-cost advantage, reputation, etc.)

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